What is the difference between Effective and Marginal Tax Rates?

Taxes can be complicated and the rules change quickly. It’s important for people to understand the basics so they can maximize savings and also avoid underpayment. Two important pillars of income taxes are the effective and marginal tax rates. Both rates determine how much taxes an individual owes but do so in different ways. Effective Tax Rate The effective tax rate is the average tax rate a person or organization pays. It is represented as a percentage and represents the share of income that is used to pay Federal taxes. Calculating the effective tax rate can be a more accurate way of knowing what your tax bill is than relying on your tax bracket. To calculate the effective tax rate, you divide your total taxes by your taxable income. The effective tax rate is usually lower than the marginal because your income is taxed at lower rates first before laddering up to a higher rate. As you’ll learn later on, marginal tax rates are based on your highest tax rate. Example of Effective Tax Rate The equation for the effective tax tax rate is: Total